Markets, Market Failures, and Development

Abstract

A central question in development economics is, how can we account for differences in the levels of income and the rates of growth between the developed and less developed economies? In the 1950s and 1960s, there was a standard answer to this question: the poor are just like the rich, except they are poorer-they have less human and nonhuman capital. There was an immediate prescription for this diagnosis: increase the resources of LDCs, either by transferring capital to them (either direct aid or education) or by encouraging them to save more. Today, these answers seem less convincing that they did two decades ago. If the problem were primarily a shortage of physical capital, the return to capital should be much higher in LDCs than in developed countries, and the natural avarice of capitalists would lead to a flow of capital from the more developed to the less developed economies (see Howard Pack, 1984 and my 1988 paper). If the problem were primarily a shortage of human capital, then the educated in LDCs should receive a higher (absolute as well as relative) income than the educated in more developed economies. How then can we account for high levels of unemployment among the educated and the migration of the educated from LDCs to more developed economies? Moreover, the predictions of the standard neoclassical growth model, of a convergence of growth rates in per capita income, with permanent differences in per capita consumption being explained by differences in savings rates and reproduction rates, do not seem to have been borne out. These observations suggest that the LDCs differ from the developed countries in at least some other important respects, and this view is corroborated by those studies which have looked at the productivity of similar plants operating in developed and less developed economies. (See Pack, 1984; 1987.) The difference can be attributed, perhaps tautologically, to differences in economic organization, to how individuals (factors of production) interact, and to the which mediate those interactions. Among the most important of these institutions are markets. It is by now well recognized that there are many instances of market failures in more developed economies (see Bruce Greenwald and myself, 1986). In some cases, market failures may be ameliorated by nonmarket institutions. If, for instance, capital markets do not function well (perfectly), if only because of costly and imperfect information, nonmarket (internal capital markets within large conglomerates) may develop.' Market failure is more prevalent in LDCs, and the nonmarket that ameliorate its consequences are, at least in many instances, less successful in doing so. The objective of this paper is to explore the causes and consequences of these market failures and the failure of private nonmarket solutions, and to suggest possible roles for government intervention. tDiscussants: Anne 0. Krueger, Duke University; Stanley Fischer, World Bank.